MONEY MONDAYS: FICO Credit Score News and What It Means for You

Mellody Hobson is President of Ariel Investments, a Chicago-based money management firm that serves individual investors and retirement plans through its no-load mutual funds and separate accounts. additionally, she is a regular financial contributor and analyst for CBS news.

Tom: We have news that actually might be working in our favor this morning!

Mellody: Yes we do! I know our weekly talks sometimes focus on things that you have to look out for – last week’s segment on digital security comes to mind – but today we have some positive news as it relates to credit scores. Last week, fair Isaac Corporation, or FICO, announced that the company will be making changes to the algorithm they use to calculate your credit score, and these changes have the potential to give many individuals a positive bump up when it comes to their credit score. This is a big deal, because almost 90% of consumer lending decisions in this country are made using fico scores to determine eligibility and interest rates!

Tom: Tell us about the changes that are being made.

Mellody: The first big change that FICO is making relates to medical debts that consumers may have incurred. We talked about these medical and healthcare bills in April, tom. according to analysis done by the new york times earlier this year, around 40 – that’s four zero – percent of mortgage applicants had medical debts in collections, and the average debt was around $400. Why does that matter here? Fico has announced that the new version of its score will no longer weight these medical debts — which account for about half of all unpaid collections on consumers’ credit reports — as heavily they had been weighting them previous.

The other good news for consumers is that if you are working on getting caught up on past bills; FICO is now going to reward you a little bit for your efforts. The newer fico score will no longer take into account any collections that you have already paid, whereas they had previously counted paid and unpaid collections. Mind you, debts under $100 dollars had been ignored prior to this, but this is still great news if you missed a payment over $100 dollars at some point but have now paid it off.

Tom: This is great! When you say people can get a boost in their credit score, what do you expect?

Mellody: based on the new model, people who have a median score with a clean credit history but unpaid medical bills could see their fico score rise by about 25 points. Now, the median credit score is 711, so the bump will vary depending upon other information in your credit history and the size and scope of the medical debts that are currently in collections. Now the other change, relating to bills or debt that has been in collection but are now settled will also improve consumer’s scores, though it is likely that the impact on your fico score will not be as significant. Obviously, those who will be getting the biggest boost will be individuals who have had significant medical debts in collections in the past but have paid off these bills, resulting in a double effect of sorts.

It is important to note that the difference between the old scoring system and the new system are probably not going to result in a person getting approved for a loan if they were previously denied. In most cases, the big impact for the consumers who benefit from these changes will be lower interest rates.

Tom: What are there any catches?

Mellody: I wouldn’t call it a catch, but it is important to note that for consumers to see any benefit from these changes, lenders will have to adopt the new scoring techniques. Fico last introduced a new model in 2008, and the company has said that only about half of its client companies have that model. And mortgage lenders have been even more reluctant to adopt new scores, with most lenders using even older versions. The reason? Fannie Mae and Freddie mac, two huge players in the housing markets, still use the old scoring technique in their own underwriting software. So, even if your FICO score improves under the new system, a lender has to have adopted the new system for you to benefit.

Tom: Anything else we should know?

Mellody: The last thing I want to do is to remind our listeners how important their credit score is, and how important it is to protect it and work to keep it as high as possible. Your credit score is basically your entrance exam for any type of credit – from an auto loan to a credit card – so you cannot just rely on a new formula like the one that fico has announced to help you out. It is really important for listeners to work to improve your credit score. As i mentioned in April, talk to your doctor’s office and any other medical office that you have been to in the last few years to better understand the billing process and know what the charges are. Sign up for automatic payments for your monthly bills. Work to consolidate your credit cards with the goal of getting down to one and paying it off monthly. These are small steps that will help you improve your credit score and put you on a better financial footing, regardless of which scoring system lenders rely on. If you do this, you will be in a good place!